Where to Put your Investments for Maximum Tax Efficiency

I’ve been getting a number of emails from readers about dividend investing and which type of investment account to use for maximum tax efficiency. This article should help clear up some of those questions. This post has been modified and expanded but was originally written in 2009.

Efficiency is the name of the game not only with investing but with many aspects of life. For the next few moments, let’s focus on tax efficiency within your investment account.

Investors talk a lot about diversification and asset allocation, but what about portfolio allocation? That is, once the diversified investments are chosen, where do I put them for maximum tax efficiency?

Basically, portfolio allocation is the most tax efficient way to hold your securities based on the taxation of both the security and the account in the view that all your assets are a giant portfolio instead of multiple sub accounts. At least that’s how I define it. :)

Backgrounder on Investment Taxation

Let’s take a look at various investment instruments and their tax consequences:

Canadian Dividends – Dividend tax credit makes Canadian dividend income relatively tax efficient in a non-registered (ie. taxable) account. The higher your income, the less tax efficient Canadian dividends become.

Foreign Dividends – In non-registered accounts, foreign dividends are taxed 100% at your marginal tax rate (ie. if you are in the 40% tax bracket, you will pay $40 in tax for every $100 foreign dividend). In TFSA’s foreign dividends will face a non-recoverable withholding tax.

Bonds/GICs/Money Market – In a taxable account, interest is taxed at 100%.

Big Picture Portfolio Tax Efficiency

Before I get into where each investment belongs, there is a broader discussion of taxation of accounts after retirement. A number of people out there think that RRSPs are a scam or a rip-off. That is simply not true. There are groups of investors that would benefit from RRSPs (see below) and also some that will not benefit at all.

An RRSP is essentially a reverse TFSA (ie. RRSP you are contributing pre-tax, TFSA you are contributing post-tax). However, there is an exception. The big advantage of TFSA withdrawals are that they do not count towards government program thresholds (like guaranteed income supplement and old age security – avoiding clawbacks in these programs explained in links below). If interested, here is more on retirement income sources.

Some general guidelines:

If you are low income with savings, take advantage of TFSAs and avoid RRSPs (to reduce GIS clawback).

If you are high income, take advantage of both RRSPs and TFSAs.

If you expect a large government or other defined benefit pensions in retirement, maximize TFSAs before RRSPs (to reduce OAS clawback).

Maximizing Tax Efficiency in your Portfolio

Now that we have the big retirement picture out of the way. Let’s get down to the crux of the topic – where should you put each investment type?

As a general conclusion, you’ll want to maximize tax-sheltered accounts before putting investments within a taxable account.

Here is an example of an index investor with a simple portfolio that may consist of globally diversified index funds/ETFs, bonds, and cash.

Final Thoughts

One word – efficiency! It generally makes sense to maximize your registered investment accounts before moving into taxable accounts. However, if you save more than your tax-sheltered accounts will allow, you may want to shuffle around your investment assets to minimize taxation where possible.

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About the author: FT is the founder and editor of Million Dollar Journey (est. 2006). Through various financial strategies outlined on this site, he grew his net worth from $200,000 in 2006 to $1,000,000 by 2014. You can read more about him here.

The book Intelligent Portfolio calls the concept “Household Portfolio”.

You’ve left out RESPs; what sort of investments should go there? I would argue that you should not put highly volatile investments here; there is a risk that your children won’t go to school or won’t use it all… what if high risk investments perform like gang-busters?

I also like bonds in the TFSA versus RRSP because they can serve as an easily available emergency fund, but maybe the easy availability is a bad thing…

The decision to prioritize between RRSP and TFSA depends on whether or not you expect to increase your income in the future (thus, higher tax). If the answer is yes, TFSA makes sense, if no, RRSP may be the best (RRSP makes the most sense if you expect your future income to drop.)

As somebody in the beginning of the career, I plan to fund TFSA first and then RRSP (at least enough to drop my gross to the next tax bracket). Yes, I read all the gloomy news on the weekend, but I don’t need any of my money in RRSP or TFSA for 30-40 years, so my portfolio is quite aggressive.

TFSA
– 100% Equity (Planned): I’m planning to start with American equities and then add world equities.

Non-Registered
– Individual stocks (For the time being, I’m not using this as a serious investment vehicle. I have a fairly insignificant amount of money in here to play around with stocks for learning.)

Bernstein (Four Pillars of Investing) is pretty big on the one portfolio idea. In my opinion it makes sense for similar accounts ie if you have several retirement accounts (2 rrsps, 1 spousal rrsp, pension) then it makes sense to combine them when looking at your asset allocation.

In theory you can combine your short term accounts (emergency fund, cash in bank) into that portfolio as well but I don’t really see the point. Short term accounts are always going to be cash (or something similar) so combining them with your retirement savings isn’t going to change that.

RESP is another account that I analyse separately because it has a different timeline than all the other accounts and a different asset allocation.

I also look at the RESP account separate from all the other accounts. The investment timeline is very different. I am just about to start withdrawing from the RESP account but I am many years away from withdrawing from the other accounts.

I have treated our investment portfolio as one big combined group, allocating funds to each investment slot based on what types of investments are tax favourable. Another thing to note in the above list is capital gains: those are only taxed at 50% if held outside of your RRSP. This is a major advantage. A capital gain in an RRSP, while not taxed at the time it is made, is taxed at 100% of the gain when withdrawn. Unless you expect your tax rate to be signifcantly lower upon retirement when you withdraw your RRSP funds, capital gains are better off made outside your RRSP. Even better, capital gains are not taxed at all inside a TFSA. That makes your TFSA the much better choice to locate any investments that are capital gains focused.

For my wife and I, our TFSA’s are the place where we hold fixed income securities. This is the “safe” part of our portfolio where the interest income is earned tax free. In a couple of years, once our contribution room grows to a higher percentage of our overall investment portfolio, I will begin investing in capital gains focused investments as well.

RRSP’s is the place I hold mostly foreign equities.

Outside, in a taxable investment account, we hold our Canadian dividend earning portfolio. These dividends are taxable each year, but with the dividend tax credit (something you don’t get in your RRSP, you pay full tax upon withdrawal) it makes it advantageous to hold these stocks in a taxable account.

It ultimately depends on what your tax bracket is now and what you expect your tax bracket to be upon retirement. As I expect my post-retirement income to be comparable to what it is now, I am not maxing out my RRSP (I am focusing on a spousal primarily, as my wife’s income after retirement will be much lower than mine). I also have a fear that our tax rates are going to be much higher than they are now in 10-15 years. We will have a lot of boomers to fund retirement for and a less productive nation (per capita) to fund it with.

Portfolio allocation I definitely a very complex topic to understand and with the TFSA this year it only gets harder. Most of how you allocate your portfolio will depend on your personal situation (tax bracket, time, family, future plans). I personally am trying not to fully maximize my RRSP, this is because I am in a low tax bracket and am expecting be in a higher tax bracket in a few years.
I also may need to withdraw from the investments over the next couple of years, so having it in RRSP right now will be very counter productive, as I will get tax refund on a lower tax bracket and will be taxed at a higher tax bracket.

Regarding “In TFSA’s, right now, it seems foreign dividends will face a withholding tax”. Do you know that is 15% if you filled in that form with your broker or it is 30% regardless.
Also do you have any idea inside the RSP the withholding tax is 0?

For instance I use E-trade and part of the account opening process is either a form W8-BEN or a copy of your canadian driving license. With that on file though I would assume the tax should be less meaning just 15% inside the TFSA no? And for RSP 0 foreign tax as I think I’ve read somewhere that the RSP is covered under a tax treaty with the US. Oh yes I was speaking here about US dividends. For other countries I have no clue… for instance how much gets withheld for an Asian dividend.

mjw, wxjunkie: I will most likely be purchasing individual REITS as REI.UN is a large portion of the XRE ETF reit index. I actually haven’t had the chance to open a tfsa yet, but when I do, it will be with Questrade..

I am a fan of having REITs in the TFSA and bonds in the RRSP, since the REITs are likely to grow at a faster rate and then be tax free at retirement. With RRSP room towards retirement and looking to change my portfolio, I would also be able to sell REITs from the TFSA and buy more bonds in an RRSP.

When (if) I retire, I would like to have most of my money in a TFSA and just enough in the RRSP so that my monthly withdrawals are well under the basic personal tax exemption (i.e. less than about $850 per month in 2009 dollars), and I can get the Canada pension if it still exists. I’m still sort of young so the TFSA wins.

dumdumdum,
$5000 per year, even when contributions are indexed for inflation, would likely be about $500,000 in 30 years. (based on 5% growth and 2% inflation)

For the average Canadian $5000 is about 7% of their income, an RRSP allows contributions of about 18% or about 2.5 time as large an investment. You might find your retirement sorely lacking if you are depending on the income from the TFSA to make up the difference in your retirement income.

Your plan would have you earning about $4000 per month tax free in 2040 dollars, about equal to living on $2000 / month today, plus of course any other government supported income you may be able to access at that time.

At this point I’ve opted to look at our family accounts (1 spouse, 2 kids) as 3 categories:
1. RESP: one family RESP in a self directed account.
2. Non-Reg/TFSA: two of each, treated as one allocation
3. RRSP: two accounts, treated as one allocation (just starting to convert to this from years of independent management)

I would like to get some advice/feedback on how best to approach #3 however. At the moment, we have the exact same stocks/ETFs in each account – hence two buys, two sells for everything. I’ve been thinking about breaking this down (e.g. 3 in one, 3 in the other instead of 6 in each) to minimize trading costs, and easier tracking.

How best do I break this down? Both accounts are roughly the same size and assuming a simple 50% Canadian equity, 30% Foreign equity and 20% Fixed income allocation (simple illustration), how does one spread this across two accounts? Canadian equity in one and the foreign/bonds in the other? I think rebalancing will be very difficult with this model since I can’t move things between accounts.

I need to thing more seriously about this – I’m sure many of you have so I’d like to hear what you’ve come up with!

Interesting thread. A question for all of you….how many of you hold CDN dividend-paying stocks in your RSP? I would seem to be a good move to hold them inside an RSP (for long-term equity growth) and outside, to take advantage of low taxation…

Mark, if you are considering holding dividend stocks for the long term (aka until retirement), the holding them outside your RRSP provides many benefits. First, you get the dividend tax credit, and second, you’ll only be taxed on the capital gains when you sell. Within an RRSP, you’ll pay no tax on the dividends, but you’ll have to pay tax on RRSP withdrawals at your marginal rate.

As well, depending on your income and province, dividend income outside an RRSP can be extremely tax efficient. For example if you are from Ontario, you can make up to $70k in regular income and only pay around 7% tax on dividend distributions.

I hold exclusively dividend stocks in all the accounts. In fact, I have more in US stocks now than Canadian and I am starting to spill outside the RRSP account. I am well aware of the tax on the dividend but when I look at the total return of the investment, the tax is a small fee to earn more.

A foreign tax on a 1.5% yield is not much when a stock like Visa has an ROE of 26%.

Your advice on where to place international exposure is incorrect. Non-registered accounts is where you want your international exposure because the withholding taxes are not recoverable in TFSAs or RRSPs.

I hold no bonds but keep reits & restaurant shares in my TFSA, my RRSP is simply XWD, which is 50% US & 50% the rest of the world. My non registered stocks are 60% large cap Canadian dividend stocks & 40% US non dividend paying stocks BRK.B I pay no withholding taxes that way and Berkshire is like a small etf into itself.

If you segregate your funds for tax efficiency, how do you handle rebalancing as you can’t easily move funds between the accounts and may not have space in TFSA/RRSP to add new positions. Does this loss of rebalancing power affect long-term returns?

This is how I do it:
TFSA – passive aggressive – all of your stocks, well diversified. XAW and ZCN.

RRSP – US and International equities are great here if you use ITOT/VTI and VXUS or VT to save on foreign withholding tax. Bonds are okay in an RRSP as well.

Non-registered – tax-efficient bonds that have lower income and lower capital gains. I like using HBB, but if you don’t like the total-return swap, then ZDB. Once you’ve put your tax efficient bonds in a non-registered, Canadian stocks can go in.

RESP – needs to be it’s own complete portfolio, if you’re at TD, use the 4 TD e-series, otherwise use VGRO/VBAL/VCNS depending on how many years left and switch to GICs near the end. Use a discount broker without ETF trading fees.

I had a discussion with an accountant a while back regarding REITs in a non-registered account. Technically, due to the return of capital included in many distributions, you end up with a potentially more favorable tax rate when all is calculated in a non-registered account since you convert the distribution to capital gains. Obviously, it doesn’t beat no tax but when it comes to choosing your holding location within a taxable account, REITs may be more favorable to dividend stocks. Again, compare the amount you get as a stock with 1% yield cost a different amount than 5% yield in taxes.

A REIT can provide interest, dividend, ROC and even foreign dividend. ROC can be a major part of the distribution which technically converts your distribution into future capital gains. Since the capital gains tax rate is the most favorable tax rate of all, there should be a consideration to have your REIT in a non-registered account over regular stocks.

Great summary!
Note that if you hold U.S. stocks in a taxable account, they are subject to a 15% withholding tax (although in most cases you can get a Canadian income-tax credit to offset that tax). However, if you hold U.S. stocks in an RRSP, no taxes are withheld at all.

Hi there,
With the passive income rules regarding corporations. Has your approach to saving within your corp and investing changed? What would be your recommendations for tax efficiency within a corporation (assuming already maxed out TFSA and taking some salary for optimizing RRSP to some extent and being able to collect CPP later on). Thanks for your insights Sue

Hey FT, you recommend holding an international (not including US) such as XEF in you RRSP. Is there any difference holding this in either your RRSP and TFSA? My understanding is that it would be subject to withholding tax either way.